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Here's the current state of play: The US is mired in slow growth, but not contracting (here in Q3). A fiscal and monetary response is likely to be forthcoming in the next few weeks. The eurozone slowed dramatically and Q3 is off to a poor start. Fiscal policy is off limits as the austerity regime remains in control. The ECB may soften its stance but is unlikely to cut rates, and the ascension of Draghi would seem to make it more difficult. Japan's recovery is meeting international headwinds and the new government looks a lot like the old. The MOF's capex survey warns that Q2 GDP is likely to be revised down to -0.5/-0.6% from -0.3% initially.
The US
There is little good that can be said about the US employment figures. The decline in the work week is more important to me than the weak private sector job growth. In terms of aggregate hours worked, the index is the lowest since April. I also find it remarkable that once recognized as a lagging indicator, many pundits are now embracing US employment data as a leading indicator.
The US fiscal policy response will come prior to the next FOMC meeting. The poor jobs data should embolden Obama. Extending unemployment benefits through 2012 is bare minimum. These are about to expire and would withdraw some $45 bln, according to estimates. Estimates suggest that a combination of extending a payroll tax holiday and extending emergency unemployment benefits would protect around 600k jobs.
Block grants to states is thought to be among the most effective uses of fiscal dollars for jobs. An infrastructure bank may be proposed as well, but that likely stops well shy of a real job program like the WPA. Talk of a mortgage interest break to the millions of homeowners that Fannie and Freddie hold the paper for is running into a number of technical roadblocks, according to Washington-based contacts.
The Federal Reserve meets later in the month. Some additional action is likely. The options are clear even if limited. Extending maturities is seen as the most likely step and the least objectionable to the hawks. A cut in interest paid on reserves is not perceived to be very effective. Net buying of more assets still seems unlikely at this juncture. The risk of deflation has all but evaporated.
There has been some talk of the Fed formalizing its inflation target, but that also does not seem particularly effective. The Fed could tie its policy to the level of unemployment. For example, it could say that as long as unemployment is above 8%, it will be stimulative, but after putting a two-year time frame on its extended period, it is unlikely to go further down that road at this juncture.
Eurozone
The policy flexibility the US enjoys, even after the S&P downgrade, stands in stark contrast to Europe. Fiscal policy cannot be used in the eurozone. In fact, the austerity is exacerbating the economic downturn. Like in July 2008, the ECB chose to tighten policy just as the eurozone economy began to wither. After growing a heady 1.5% in Q1 (quarter-over-quarter), Germany slowed to 0.1% in Q2 and little improvement is seen here in Q3.
The zone's manufacturing PMI hit a two-year low in August at 49.0, down from the 49.7 flash reading and down from 50.4 in July. Output fell to 48.9 from 50.2 and new orders fell to 46.0 from 47.6.
While Germany and France are slowing, Italy and Spain's showing warns of additional fiscal strains. Slower economic performance impact the deficit directly and indirectly. Italy's manufacturing ISM slumped to 47.0 form 50.1 in July. New orders collapsed to 44.0 from 48.5. Spain slipped to 45.3 from 45.6 in July. August was the fourth consecutive month of sub-50 reading.
The ECB meets next week. The staff will likely cut its inflation and growth forecasts. Trichet is likely to sound less hawkish, but not very dovish. A rate cut would not seem very ECB-like as it would be admit that the April and July rate hikes were a mistake. It reversed itself in 2008 but only after the demise of Lehman as the crisis reached historic proportions.
Two additional issues bedevil the zone. First, the ECB/IMF/EU troika has cut short its review of Greece. At stake is the next tranche of aid. The problem is that Greece is falling short of its budget targets and appears increasingly reluctant to promise more austerity. Also disheartening, Greece's budget auditor quit in a fight with the finance ministry. Greece's deficit this year was to be 7.6%, but it appears to be at least 1 percentage point higher. Growth is likely to be more than 1 percentage point lower than the government's recent forecast of -4.5%. This coupled with the dispute over collateral is weighing on Greek debt prices, with the two-year yield rising to new EMU-era highs and its five-year CDS is approaching its record high set in July.
The second issue that is challenging European officials is Italy. Recall that in late July the ECB was not prepared to buy Italian or Spanish bonds. It insisted on new austerity measures. Italy at first delivered, but in recent days, Berlusconi, who had said his "heart was bleeding" over the tax increases, appears to be backtracking. At the same time, the ECB had scaled back its bond buying and its 10-year bond yield has risen for 11 consecutive sessions through today and at 5.28% is the highest since Aug 8. Its five-year CDS is at a new record high.
On the same day that President Obama is to deliver his economic speech -- Sept. 7 -- that may be best seen as his first campaign speech for the 2012 election, the German Constitutional Court is expected to hand down its decision about the EFSF reforms. This is a wild card I have highlighted before. While the court is unlikely to scuttle the agreement, it is likely to enshrine a role for the German parliament. In effect it will have a veto over who gets EFSF funds, including the precautionary lines of credit.
Lastly, I note that Ireland still seems to me to be the best of the peripheral bunch. The lower volatility of its bond market has prompted LCHClearnet to lower the margin to 55% from 65%. It is running a trade surplus and at 1% its CPI is well below the euro zone average, which is suggesting of recouping some competitiveness. Its August manufacturing PMI rose to 49.7 from 48.2.
Other Europe
The Bank of England meets on Sept. 8. No change in policy is expected. It is facing a stagnating economy and there may increasing confidence that inflation pressures will ease. Still it is too early to realistically expect a rate cut or increased asset purchases.
The slowing of the eurozone economy should further deteriorate the UK outlook. The British Chamber of Commerce cut its GDP estimate for the third time this year to 1.1% from 1.3% and 1.9% at the start of the year. Next year's growth is still put at 2.1% (down from 2.2%), which still seem high, given the fiscal tightening that kicks.
Sweden's Riksbank meets on Sept. 7. Although the central bank had previously hinted at the need to continue to normalize policy, the weakness of recent data suggests this is unlikely to be forthcoming. In fact, if it does raise rates, counter-intuitively the krona may sell-off. Note the manufacturing PMI came in at 48.7 in August down from 50.1 in July. Sweden exports a bit more than 40% of GDP. The weakness in its PMI says something about the Swedish economy, but also something about the world economy. And it isn't good.
Dollar-Bloc
The Reserve Bank of Australia meets on Sept 6. Rate cut speculation has been widespread, but recent data and official comments warn that such speculation may be disappointed. Capex and retail sales are holding up. There seems not strong sense of urgency. Prudence suggests little harm in waiting another month.
The Bank of Canada also meets on Sept. 7. Of the central banks that are meeting, the risk of surprise from the Canada seems greatest. The case for a rate cut is partly in a preemptive action given that the anticipation of some additional non-orthodox easing from the Federal Reserve and the weakness of the US economy.
Canada reported in recent days that its economy contracted in Q2 by 0.4% at an annualized clip. The consensus had looked for a flat reading. This follows a revised 3.6% Q1 pace (down from 3.9%). Although the economy seemed to finish Q2 on better footing, the external risks are looming and the price of oil has fallen considerably.
A cut by the Bank of Canada would be also be in a similar vein as the recent rate cuts by Turkey and Brazil, both of which the market did not expect and seems preemptive in nature to head off impact from additional easing by the US.
Japan
The Bank of Japan holds a two-day meeting on Sept. 6-7. It is too soon for new asset purchases. It may identify the strength of the yen and global uncertainties as headwinds. Intervention in the foreign exchange market, you will recall is a MOF decision (as it is the Treasury's decision in the US).
Japan has a new prime minister, who appears to have authorized the record one day intervention (JPY4.5 trillion) in early July. Noda's first choice for the finance ministry turned it down. Azumi, a conservative by temperament and politics took the post, underscoring the perception that the new administration represents "old wine in new skins."
I have argued that the yen's strength is not just a function of its safe haven status as the world's largest creditor (net international investment position), but also because interest rate differentials have moved in its favor. I had noted that the two-year US-Japan differential is sitting at its lowest level since the early 1990s just above 0. Following the US jobs report, and ideas that the Fed may lengthen maturities of its Treasury holdings, the US 10-year yield fell to less than 100 bp above Japan's 10-year yield for the first time since late 2008.
The dollar-yen has found support near JPY76.00 The fact that the Swiss franc, the other safe haven currency, strengthened so much (~2.4% against the dollar over the past five sessions and 4.5% against the euro) appears to have taken some pressure off the yen. Note that the past week was the first in four that foreigners were not buyers of Japanese bills. Recall that some real money managers cannot take on naked currency exposure so when bullish the yen, they often buy bills.

More Thoughts

Three observations about the euro seem worthwhile to share. First, the US-German two-year interest rate differential is collapsing. It stands near 32 bp presently. What a round trip this year. It began off the year at 20 bp (that is, the US is offered 20 bp less than Germany). From the first ECB press conference of the year, when Trichet sounded hawkish, the spread trended higher, in Germany's favor. It reached over 130 bp as the euro peaked in early May. It has trended lower and now is at at lowest level since around that first ECB press conference. The euro exchange rate is of course significantly higher, but the collapse of its premium is suggestive of its vulnerability.

The second observation is that the euro longs are rightly nervous. This can be seen in the risk-reversals. Put-call parity states that puts and calls equidistant from at the money forward should sell for the same price. To the extent they don't, reveals something about market expectations. The euro puts (standard 25 delta) are trading at about 3.4% more than euro calls. The record was set on Aug. 9 (according to Bloomberg data) near 3.56%. The difference is a little more than the indicative spread between bid and offer.

Third, the five- and 20-day moving averages are crossing to the downside. This is often a good guide to the near-term trend. However, the euro has been range-bound and the moving averages have been chopped up as of late. Yet the technical tone is poor. The mild up trend line (drawn connecting the July 11 and Aug. 5 and Aug. 11 lows) has been convincingly violated (two consecutive closely below and comes in just below $1.43 now). The near-term risk extends toward $1.40. That said, the wider range -- $1.40-1.46 -- must be assumed to remain intact until it proves otherwise.

Sterling's five- and 20-day moving averages crossed on Aug. 29. It trend line drawn off the July 12 low (caught the Aug. 11 and Aug. 28 lows) has also been successfully broken. Important support is now seen near $1.6100.

For a punt, I like the Australian dollar against the New Zealand dollar. In these choppy markets, money management is key. I suspect the market has gotten ahead of itself on an RBA cut and it is expensive to be short the Aussie for long. Technically, it looks like a head and shoulders bottoming pattern has been carved out. I would be wrong on a break of NZD1.25 and a move above NZD1.28 (the initial target) would lend support for a bigger move.

Disclosure: No positions

Source: Forex: Second Verse, Same As The First